Please refer to the Financial Management Revision Notes given below. These revision notes have been designed as per the latest NCERT, CBSE and KVS books issued for the current academic year. Students will be able to understand the entire chapter in your class 12th Business Studies book. We have provided chapter wise Notes for Class 12 Business Studies as per the latest examination pattern.
Revision Notes Chapter 9 Financial Management
Students of Class 12 Business Studies will be able to revise the entire chapter and also learn all important concepts based on the topic wise notes given below. Our best teachers for Grade 12 have prepared these to help you get better marks in upcoming examinations. These revision notes cover all important topics given in this chapter.
Financial Management: Definition
Financial Management is concerned with optimal procurement as well as usage of finance.
The prime objective of financial management is to maximise shareholder’s wealth by maximising the market price of a company’s shares.
Financial Decisions Involved in Financial Management
- Investment Decision
- Financing Decision
- Dividend Decision
Role of Financial Management
- To determine the capital requirements of business, both long-term and short-term.
- To determine the capital structure of the company and determine the sources from where required capital will be raised keeping in view the risk and return matrix.
- To decide about the allocation of funds into profitable avenues, keeping in view their safety as well.
- To decide about the appropriation of profits.
- To ensure efficient management of cash in order to ensure both liquidity and profitability.
- To exercise overall financial controls in order to promote safety, profitability and conservation of funds.
- It seeks to determine as to how the firm’s funds are invested in different assets
- It helps to evaluate new investment proposals and select the best option on the basis of associated risk and return.
- Investment decision can be long-term or short-term.
- A long-term investment decision is also called a Capital Budgeting decision.
Types of Investment Decision
1. Working Capital/Short-term Investment Decision
- It refers to the amount of capital required to meet day- to-day running of business.
- It relates to decisions about cash, inventory and receivables.
- It affects both liquidity and profitability of business.
2. Capital Budgeting Decision/Fixed Capital/Long-term Investment Decision
- It refers to the amount of capital required for investment in fixed assets or long term projects which will yield return and influence the earning capacity of business over a period of time.
- It affects the amount of assets, competitiveness and profitability of business.
Factors Affecting Capital Budgeting Decision/Long- term Investment Decision
- The expected cash flows from the proposed project should be carefully analysed. o The expected rate of return should be carefully studied in terms of risk associated from the proposed project.
- Different types of ratio analysis should be done to evaluate the feasibility of the proposed project as compared to similar projects in the same industry.
Financing Decision: Definition
Financing decision relates to determining the amount of finance to be raised from different sources of finance. This decision determines the overall cost of capital and the financial risk of the enterprise. Types of Sources of Raising Finance
1. Owned Sources
- Equity shares
- Preference shares
- Retained earnings
2. Borrowed Sources
- Loan from bank or financial institutions
- Public deposit
Considerations Involved in the Issue of Debt
- Interest on borrowed funds has to be paid regardless of whether or not a business has made a profit. Likewise, borrowed funds have to be repaid at a fixed time.
- There is some amount of financial risk in debt financing.
- The cost of debt is less than equity as the degree of risk assumed by the investors is less and the amount of interest paid by the company is tax deductible.
Factors Affecting Financing Decision
- The source of finance which involves the least cost should be chosen.
- The risk involved in raising debt capital is higher than equity.
- The sources involving high flotation cost require special consideration.
- If the cash flow position of a business is good, it should opt for debt else equity.
- If the fixed operating cost of a business is low, it should opt for debt else equity.
- The issue of equity capital dilutes the control of existing shareholders over business whereas financing through debt does not lead to any such effect
- If there is boom in capital market it is easy for the company to raise equity capital, else it may opt for debt.
Considerations Involved in the Issue of Equity
- Shareholders do not expect any commitment regarding the payment of returns or repayment of capital.
- The floatation cost on raising equity capital is high.
- The shareholders expect higher returns in return for assuming higher risks.
Dividend Decision relates to disposal of profit by deciding the proportion of profit which is to be distributed among shareholders and the proportion of profit which is to be retained in the business for meeting the investment requirements.
Factors Affecting Dividend Decision
1. Earnings: Companies having high and stable earning could declare high rate of dividends as dividends are paid out of current and paste earnings.
2. Stability of Dividends: Companies generally follow the policy of stable dividend. The dividend per share is not altered and changed in case earnings change by small proportion or increase in earnings is temporary in nature.
3. Growth Prospects: In case there are growth prospects for the company in the near future them it will retain its earning and thus, no or less dividend will be declared.
4. Cash Flow Positions: Dividends involve an outflow of cash and thus, availability of adequate cash is for most requirements for declaration of dividends.
5. Preference of Shareholders: While deciding about dividend the preference of shareholders is also taken into account. In case shareholders desire for dividend then company may go for declaring the same.
6. Taxation Policy: A company is required to pay tax on dividend declared by it. If tax on dividend is higher, company will prefer to pay less by way of dividends whereas if tax rates are lower then more dividends can be declared by the company.
7. Issue of bonus shares: Companies with large reserves may also distribute bonus shares to increase their capital base as it signifies growth of the company and enhances its reputation also.
8. Legal constraints: Under provisions of Companies Act, all earnings can’t be distributed and the company has to provide for various reserves. This limits the capacity of company to declare dividend.
Financial Planning: Definition
The process of estimating the funds requirement of a business and specifying the sources of funds is called financial planning. It basically involves preparation of a financial blueprint of an organisation’s future operations.
Twin Objectives of Financial Planning
- To ensure availability of funds as per the requirements of business.
- To see that the enterprise does not raise resources needlessly. Importance of Financial Planning
- It ensures smooth running of a business enterprise by ensuring availability of funds at the right time. ? It helps in anticipating future requirements of funds and evading business shocks and surprises.
- It facilitates co-ordination among various departments of an enterprise, like marketing and production functions, through well-defined policies and procedures.
- It increases the efficiency of operations by curbing wastage of funds, duplication of efforts, and gaps in planning. .
- It helps to establish a link between the present and the future.
- It provides a continuous link between investment and financing decisions.
- It facilitates easy performance as evaluation standards are set in clear, specific and measurable terms.
Financial Risk: Definition
It refers to a situation when a company is unable to meet its fixed financial charges like payment of interest on debt capital.
Trading on Equity: Definition
It refers to the increase in the earnings per share by employing the sources of finance carrying fixed financial charges like debentures (interest is paid at a fixed rate) or preference shares (dividend is paid at fixed rate).
Financial Leverage: Definition
The proportion of debt in the overall capital is called financial leverage. It is computed as D/E or D/D+E, where D is the Debt and E is the Equity.
Factors Affecting Capital Structure
i. Cash flow position:
a. The size of the projected cash flows must be considered before deciding the capital structure of the firm. If there is sufficient cash flow, debt cab be used.
b. It must cover fixed payment obligations w r t:
i. Normal business operations
ii. Investment in fixed assets
iii. Meeting debt service commitments as well as provide a sufficient buffer.
ii. Interest coverage ratio :
a. Higher the Interest coverage ratio which is calculated as follows: EBIT/ Interest, lower shall be the risk of the company failing to meet its interest payment obligations.
b. Low Interest coverage ratio => debt ≠ used.
iii. Debt Service Coverage Ratio:
a. Debt service coverage ratio = Profit after tax + Depreciation + Interest + Non Cash exp. Pref. Div + Interest + Repayment obligation
b. A higher Debt service coverage ratio, in which the cash profits generated by the operations are compared with the total cash required for the service of debt and the preference share capital, the better will the ability of the firm to increase debt component in the capital structure.
c. Low Debt service coverage ratio => debt ≠ used.
iv. Return On Investment:
a. If return on investment of the company is higher, the company can choose to use trading on equity to increase its EPS, i.e., its ability to use debt is greater.
v. Cost Of Debt:
a. More debt can be used if cost of Debt is low.
vi. Tax Rate
a. A higher tax rate makes debt relatively cheaper and increases its attraction as compared to equity.
vii. Cost Of Equity:
a. when the company uses more debt, the financial risk faced by equity holders increase so their desired rate of return increases.
b. If debt is used beyond a point, cost of equity may go up sharply and share price may decrease in spite of increased EPS.
viii. Floatation Cost:
a. Cost of Public issue is more than the floatation cost of taking a loan.
b. The floatation cost may affect the choice between debt and equity and hence the capital structure
ix. Risk Consideration:
a. The total risk of business depends upon both the business risk and financial risk. If a firm‘s business risk is lower, its capacity to use debt is higher and vice versa.
a. If the firm uses its debt potential, it loses the flexibility to use more debt.
b. To maintain flexibility the company must maintain some borrowing power to take care of unforeseen circumstances.
a. Debt normally does not cause dilution of control whereas a public issue makes the firm vulnerable to takeovers. b. To retain control, firm should issue debt.
Fixed Capital: Definition
It refers to investment in long-term assets.
Factors Affecting Requirement of Fixed Capital
1. Nature of Business: Manufacturing concerns require huge investment in fixed assets & thus huge fixed capital is required for them but trading concerns need less fixed capital as they are not required to purchase plant and machinery etc.
2. Scale of Operations: An organization operating on large scale requires more fixed capital as compared to an organization operating on small scale. For Example – A large scale steel enterprise like TISCO requires large investment as compared to a mini steel plant.
3. Choice of Technique: An organization using capital intensive techniques requires more investment in plant & machinery as compared to an organization using labour intensive techniques.
4. Technology upgradation: Organizations using assets which become obsolete faster require more fixed capital as compared to other organizations.
5. Growth Prospects: Companies having more growth plans require more fixed capital. In order to expand production capacity more plant & machinery are required.
6. Diversification: In case a company goes for diversification then it will require more fixed capital to invest in fixed assets like plant and machinery.
7. Distribution Channels: The firm which sells its product through wholesalers and retailers requires less fixed capital.
8. Collaboration: If companies are under collaboration, Joint venture, then they need less fixed capital as they share plant & machinery with their collaborators.
Working Capital: Definition
The funds needed to meet the day-today operations of the business is called working capital.
Following are the factors which affect working capital requirements of an organization:
1. Nature of Business: A trading organization needs a lower amount of working capital as compared to a manufacturing organization, as trading organization undertakes no processing work.
2. Scale of Operations: An organization operating on large scale will require more inventory and thus, its working capital requirement will be more as compared to small organization.
3. Business Cycle: In the time of boom more production will be undertaken and so more working capital will be required during that time as compared to depression.
4. Seasonal Factors: During peak season demand of a product will be high and thus high working capital will be required as compared to lean season.
5. Credit Allowed: If credit is allowed by a concern to its customers than it will require more working capital but if goods are sold on cash basis than less working capital is required.
6. Credit Availed: If a firm is able to purchase raw materials on credit from its suppliers than less working capital will be required.
7. Inflation: Working capital requirement is also determined by price level changes. For example, during inflation prices of raw material, wages also rise resulting in increase in working capital requirements.
8. Operating Cycle/Turnover of Working Capital: Turnover means speed with which the working capital is converted into cash by sale of goods. If it is speedier, the amount of working capital required will be less.